Here is an example of how Absorption costing can allow management an opportunity to
engage in earnings management.
Absorption Costing Example
Expense Deferral, Inc. estimates that it will need to produce 1,000,000 units for the fiscal year ending
December 31, 2011 if it is to fulfill budgeted sales and end the year with its targeted ending inventory
of 100,000 units. Variable costs of production are $10 per unit. Fixed factory expenses are
Opening inventory is $937,500 (75,000 units). Units sell for $15 each. General and administrative
expenses are $500,000 per year. Assume an income tax rate of 40%.
The company needs to achieve a net income of $1,800,000 in order to meet analysts’ forecasted
earnings. What will year 2011 net income be if the estimates above are accurate?
Cost per unit = $10 variable + $2.5M/1M fixed = $12.50
Budgeted sales = 75,000+1,000,000-100,000 = 975,000 units
Sales (975,000*$15) $14,625,000
Cost of sales
Opening inventory $ 937,500
Cost of goods manufactured (1M*$12.50) 12,500,000
Less: closing inventory (100,000*$12.50) (1,250,000) 12,187,500
General and administrative expenses 500,000
Income before tax $1,937,500
Income tax expense (7